Business Valuation : How to Value Private Limited Knowledge Based Companies

J

I

B

S

B u s i n e s s Va l u a t i o n

How to Value Private Limited Knowledge Based Companies

Master Thesis in Finance Author: Olsson, Fredrik

Persson, Martin Tutor: Österlund, Urban Jönköping June, 2009

i

Acknowledgements

There are a number of people who deserve our appreciation for their contributions in help-ing us to conduct this master thesis. Firstly we want to thank our tutor Urban Österlund who has provided us with support and guidance throughout the research. Finally, all the re-spondents from various corporate finance departments in Sweden and Norway. They have made the work possible and we wanted to send them a special thanks for taking time off to answer our questions which made our research possible.

The respondents how have participated in the study is: Jonas Ahlberg, Grand Thornton, Sweden.

Björn Gustafsson, Ernst & Young, Sweden. Sverre Krog, DnB NOR, Norway.

Hans Nyqvist, Öhrlings PriceWaterhouseCoopers, Sweden. Jan Swärd, Nordea, Sweden.

And three persons who wanted to remain Anonymous.

Jönköping, 5th _{of June 2009}

__________________ __________________

ii

Master Thesis in Finance

Title Business Valuation – How to Value Private Limited Knowledge Based Companies

Authors Fredrik Olsson and Martin Persson

Tutor Urban Österlund

Date June, 2009

Abstract

Purpose The purpose of this study is to investigate the methods used for valuating private limited knowledge based companies and if a new approach is required, create or modify a foundation that will con-stitute as a base within the valuation process.

Method This is a qualitative study using interviews to obtain primary data. People working in the valuation industry were contacted and we got eight respondents. The questions were designed to answer our purpose and research questions. Telephone interviews were cho-sen due to the fact that we believed the response would be higher. Frame of References The theories used in this section is divided into three parts; the

fi-nancial analysis including traditional valuating methods such as the Discounted Cash Flow model and relative valuating and multiples. The non-financial analysis focus on the underlying analysis consis-tent of structural- and intellectual capital and also value drivers that are creating value for the firm. In the end other theories con-cerning the analysis are presented, such as the risk-return trade-off, risk rating systems and analytical hierarchy process.

Empirical Findings In this section the presentations of the respondents’ answers and and Analysis a brief analysis related to each question. After this an extended

analysis is presented focusing on the subject and our risk scheme and guidelines we created/modified. The extended analysis is con-nected to the respondents’ answers. The purpose of this section is to have a better understanding about the risk of transient intellec-tual capital and give recommendations how to handle it. Also, guidelines of how to weight different value driver are discussed. Conclusion We concluded that all valuations utilize more than one approach in

order to estimate the most accurate value for the company. For knowledge based companies the biggest risk with a M&A transac-tion is the probability of diminishing the intellectual capital. We constructed a model that will manage this risk based on our inter-views and established theories.

iii

Table of Contents

1

Introduction ... 1

1.4 Definition of Knowledge Based Company ... 3

2

Method ... 5

2.1 Inductive Versus Deductive ... 5

2.2 Qualitative Versus Quantitative ... 6

2.3 Literature Search ... 6

2.4 Interviews ... 7

2.4.1 Interview Guide and Interview Questions ... 7

2.4.2 Our Interview ... 8

2.5 Interview Selection Process ... 9

2.6 Validity and Reliability ... 10

2.7 Criticism of Method ... 11

3

Frame of References ... 13

3.1 Motives for Valuation ... 13

3.2 Due Diligence ... 13

3.3 Financial Analysis ... 14

3.3.1 Discounted Cash Flow Model ... 14

3.3.2 Profit Margin ... 17

3.3.3 Relative Valuation Approach and Multiples ... 17

3.4 Non-Financial Analysis ... 19

3.4.1 Value Driver ... 20

3.4.2 The Structure of the Underlying Analysis ... 20

3.4.2.1 Industry Structure ...21

3.4.2.2 Intellectual Capital ...23

3.4.3 Value Drivers to Look For ... 25

3.4.4 Underlying Analysis Framework ... 27

3.5 Tax Considerations with M&A Transactions ... 28

3.6 The Risk-Return Trade-Off ... 28

3.7 Risk Rating System ... 29

3.8 Analytical Hierarchy Process ... 30

3.9 Summary of Theories ... 32

3.10 Previous Study ... 33

4

Empirical Findings and Analysis ... 34

4.1 Initial Clarifications ... 34 4.2 The Questions ... 35 4.2.1 Question 1 ... 35 4.2.2 Question 2 ... 36 4.2.3 Question 3 ... 37 4.2.4 Question 4 ... 38 4.2.5 Question 5 ... 39 4.2.6 Question 6 ... 40 4.2.7 Question 7 ... 41

iv 4.2.8 Question 8 ... 45 4.2.9 Question 9 ... 46 4.2.10 Question 10 ... 47 4.2.11 Question 11 ... 48 4.2.12 Question 12 ... 49

5

Extended Analysis ... 51

5.1 The Risk Analysis Scheme for the Intellectual Capital ... 51

5.1.1 The Categories ... 52

5.1.2 The Risk Analysis Scheme ... 54

5.1.2.1 The Steps of Risk Analysis Scheme ...55

5.1.2.2 Discussion about the Risk Analysis Scheme ...56

5.2 Guidelines to Weight Internal and External Value Drivers ... 58

5.2.1 The Process of Using the Guidelines ... 59

5.2.2 The Value Drivers in the Guidelines ... 59

5.2.3 Discussion about the Guidelines ... 62

6

Conclusion ... 63

7

Discussion and Reflections ... 65

7.1 Final Remarks ... 65

7.2 Further Studies ... 65

8

References ... 67

Appendices ... 72

Appendix 1 – Interview Guide in English ... 72

Appendix 2 – Original Interview Guide in Swedish ... 74

Appendix 3 – S&P Ratings Category Definitions ... 76

Figures and Tables

Figure 3-1 Porter’s Five Forces ... 21

Figure 3-2 The Intellectual Capital Value Tree ... 23

Figure 3-3 Underlying Analysis Model ... 27

Figure 3-4 Risk-Return Trade-Off ... 29

Figure 3-5 AHP Example ... 31

Table 4-1 Description of the Interviewees ... 34

Table 5-1 Risk Analysis of Intellectual Capital... 55

Table 5-2 Risk Rating Table ... 55

1

1

Introduction

This chapter is an introduction to the thesis. Firstly, a background about the subject is given followed by a problem discussion with research questions leading to the purpose of the thesis.

1.1 Background

At the moment of writing, Sweden is in a recession with stock markets in a free fall in the end of 2008. From an extreme high level it has made a historical quick drop to an extreme low level and by looking closer at the companies we can see that their firm value is chang-ing rapidly. These changes are not entirely dependchang-ing on conditions controlled by the com-panies, but rather changes in the business’s surrounding environment. The crises seen to-day started with a financial meltdown, resulting in a tough atmosphere to get loans granted, which will have an affect on everyone (DagensIndustri, 2009). The importance of knowing the current market value of your company and other factors around the company has in-creased. This is not only from an ownership perspective but also from the board-, account-ing-, and financial perspective a valuation is done (PriceWaterhouseCoopers, 2005). Sweden started off as an agricultural country moving on to become an industrial commu-nity and today we are heading more and more towards a service economy. In the end of the 60s more than half of the workforce was connected to the services sector and since the 80s the private services had grown dramatically and today almost three out of four paid works is in the service business. The development here in Sweden is not unique, it is something recognised in all well developed economies. In fact, the service sector was responsible for 62 percent of Sweden’s GDP in 2008 and 75 percent of the total employment (Almega, 2009).

Having a business in today’s environment there exist many challenges and changes you have to face. There exists increasing globalisation, trade liberalization, the European Union, introduction of the Euro and other factors forcing companies to determine a value for them self, the corporate world has become more dynamic. Mergers, acquisitions, divesti-tures and corporate takeovers are an increasing important part of a day’s work for many senior managers (Frykman & Tolleryd, 2003).

In March 2007 KPMG published a research paper showing that almost half of all manufac-turing companies and 75 percent of the private equity funds failed to maximize their value in the case of an acquisition. Emanuel Ramstedt, head of Strategic and Commercial Intelli-gence at KPMG, said that this is remarkable since at this time it was a seller’s market. The biggest explanation of this is that many companies are allocating more resources into the valuation when buying instead of selling, he believes this is an area of improvement. One of the most common pitfalls is that the buyer finds unwelcome surprises when doing an in-depth analysis of the company.

Since the beginning of the 1990s the focus in the business world has been to generate value for the shareholders and this has spread to business schools all over the world. Companies

2 have investment decisions where valuation methods are used to capture the shareholders value. Therefore, it is necessary for a businessman to understand how corporate value is measured. If you are not clear on how markets measure value you cannot work effectively to maximize it (Frykman & Tolleryd, 2003).

There have always existed occasional and temporary differences between the market’s opinion and the accounting reality, but in the last decade this small different has grown substantial. Showing more of a systematic miscalculation in the way the value is measured, in other words the company’s balance sheet tells another story than the reality. It has be-come clear that the real value for companies cannot only be determined on the foundation of traditional accounting principles due to the fact that many firms today is constituted mainly by intangible assets such as intellectual capital (Edvinsson, 1997).

1.2 Problem Discussion

Every asset, financial as well as real, has a value. The key to successfully investing in or managing these assets lies in understanding not only what the value is, but the sources of that value. Any asset can be valued but some assets are harder than others. How does one decide what the value of a company really is? Valuation is neither a specific science nor is it objective it is rather a subjective appreciation or judgment of the value that the appraiser concludes from his own analysis, experience and knowledge. Today, there exists no com-mon methodology when it comes to valuation of knowledge based companies and most of the methods and theories are based on investment theories. Usually it is the demand and the potential future growth of the company that will decide the value (Damodaran, 2002). Therefore, we asked ourselves the question:

What methods are used in the valuation industry to find the value of a private limited knowledge based company?

There exist a large variety of methods and tools in order to valuating a specific company, but not all of them are equally suitable (Nilsson et al, 2002). The information during a valuation is almost endless and it is based on the internal and external information from the company such as everything from macro economical- to company specifics variables. Therefore the valuation can never be perfect it is rather an approximation. One of the most problematic elements in a valuation is the intellectual capital and we ask the question:

Is it possible for the valuation industry to determine a value for the intellectual capital? And to what extend?

An investment means that one need to give up some resources today in order to receive fu-ture potential rewards. In order to know what a company is worth today one need to know what will happen in the future. We have chosen an approach aimed at constituting a ground for discussion and further investigation as a part of the final valuation

methodol-3 ogy. When valuating knowledge based companies the valuator needs to recognize the tran-sient intellectual capital and the existence of different critical value drivers for the valuation.

How does the valuation industry manage the risk of the transient intellectual capital?

The problem is that the main asset, intellectual capital and human capital, for knowledge based companies do not reflect the book value of these companies since it do not satisfy International Accounting Standards Board’s (IASB) criteria for an asset. According to IASB´s standards, an asset has to be controlled by the company as the consequence of oc-curring events and it is suppose to generate future economical rewards. Since the company cannot own its employees or their competences, they cannot control them and therefore it cannot be reported, most of the times, as an asset in the balance sheet (FAR, 2005). Most previous research and literature in the area of valuation concerns manufacturing companies as most of the theoretical framework will present. We find it interesting and challenging to go further into this specific field of valuing private limited knowledge based companies. The main focus will be on the company’s intangible assets and its transient nature. Thus, the aim is to increase the understanding and process of valuing when it comes to a merger and acquisition transactions both for people in the business and for private limited knowl-edge base companies’ stakeholders.

1.3 Purpose

The purpose of this study is to investigate the methods used for valuating private limited knowledge based companies and if a new approach is required, create or modify a founda-tion that will constitute as a base within the valuafounda-tion process.

1.4 Definition of Knowledge Based Company

The concept behind knowledge based companies might today seem as understood and es-tablished but a common accepted terminology does not exist. In previous literature and studies there exist a large variety of definitions but they all have some similar attributes and therefore the common definition of a knowledge based company is that it sells knowledge (Støy, 2007). A knowledge based company is also a service company but on the on the other hand not all service firms are knowledge based companies. A knowledge based com-pany is a service comcom-pany that adds knowledge when they deliver their services. The main assets is the employee and there special knowledge, competence and experience (Nation-alencyklopedin, 2009a).

4 Sveiby (1995) adds that knowledge based companies is a specific type of service company, where there is a closer cooperation between the parties and their production should be characterized by being:

 Not standardized  Creative

 Strongly individual dependent

 High level of complex problem solving

In figure 1-1 Sveiby (1995) present how knowledge based companies can be divided ac-cording to their customer adoption ability.

5

2

Method

This chapter motivates the research philosophies and research approach used in the thesis. It will also de-scribe the procedure of the study with ways of collecting information. A discussion of the validity and reli-ability is followed by criticism of the method.

2.1 Inductive Versus Deductive

When conducting a research paper one usually use one out of two approaches, either; in-ductive or dein-ductive reasoning. An inin-ductive method can be seen as “theory comes last” which means that the theoretical framework will be developed out of the empirical data (Mason 2002). It takes a bottom up approach, by collecting the data first through empirical observations and then try to develop a theory from the data analysis. The deductive method on the other hand takes a top down approach “theory comes first”. With this ap-proach the researcher tries to generate a hypothesis or proposition from theories of earlier research and test that with the empirical data (Saunders et al, 2007). In most research pa-pers a combination of different research methods is used, Alvesson & Sköldberg (1994) re-fers to this combination as abductive reasoning. The abductive approach begins with em-pirical findings but without disregarding the theoretical background. The analysis of the empirical findings can be combined with or preceded by research of existing theories, where existing theories may serve as a source of inspiration for the research to discover new patterns.

The aim of this thesis was to increase understanding of the relationship between the exist-ing theoretical framework of valuation and the complexity of knowledge based companies. The research examined if there existed any pattern when analyzing the primary empirical data retrieved from the interviews, on which theories and concepts that could be used and how they were combined if more than one valuation method was used. According to Holme & Solvang (1997), new and exciting knowledge can be discovered between the de-duction and the inde-duction.

Therefore the research approach of this study has both characteristics of an inductive as well as a deductive study. Since our theoretical framework and prior understanding has been helpful when retrieving the data conversely the actual retrieval and analysis of the data has helped us obtain an improved and more practical understanding of the theories. Differ-ent theories has been used to examine whether knowledge based companies could be val-ued from the existing theories of valuation, but it could also been the case that not all theo-ries were relevant. Out from this view the elements of both approaches were significant where one was used to create a better understanding of the other. This research not only tested to assess the collected data to existing proven theories but also to modify and de-velop a model and new understanding of the data. In other words, an adductive approach was most appropriate for this thesis.

6

2.2 Qualitative Versus Quantitative

The general purpose for both qualitative and quantitative methods is to give a better under-standing of the research. When conducting a study it is essential to evaluate the underlying problem in order to determine the most preferable research method (Saunders et al, 2007). With this research we intended to acquire a deeper understanding regarding the methodol-ogy of valuation concerning knowledge based companies, a qualitative strategy was there-fore chosen. Since this method emphasizes more on how the researchers can create this deeper understanding when interpreting the data and how that can constitute the founda-tion for the analysis. According to Holloway (1997) qualitative study can be conducted through different methods either through observation, interviewing or a survey research. The collection of our empirical data was retrieved from interviews with people with exper-tise and experience within the field of valuation. A lot of the information retrieved from in-terviews can be of a more complex and interwoven nature and can usually not be trans-formed into quantities (Holme & Solvang 1997). The research purpose was therefore of a more exploratory approach and not explanatory. When conducting exploratory research, qualitative data should provide deeper knowledge of the concept or the investigated prob-lem rather than giving a greater amount of data. The goal is to find unique details about the analyzed problem and being able to provide examples and through them make conclusions (Svenning, 2003).

The advantage with a qualitative research is that it will be more flexible giving the research-ers the ability to correct mistakes during the process more easily compared to a quantitative study. The answers from the interviews can be revised and if some information was miss-ing or if some answers were not satisfymiss-ing there would exist an opportunity to contact the interviewee again (Saunders et al, 2007).

2.3 Literature Search

To find the most appropriate theories and models for business valuation an investigation of existing material was conducted, leading to a previous research section. In the beginning we focused on general business valuation models such as Discounting Cash Flow model and later in the theory the focus shifted towards more intangible assets within the firm, such as intellectual capital.

In the business valuation area there are many sources of information; it comes from aca-demic journals including the Bell Journal of Economics and the Journal of Business. How-ever, the focus to gain information in the subject where on non-fiction books on the sub-ject business valuation. A selection of those books was Frykman & Tolleryd (2003)

“Corpo-rate Valuation – An Easy Guide to Measuring Value” and Damodaran (2002) “Investment valua-tion: tools and techniques for determining the value of any asset.”

7 Articles and books used during the process of this paper were found in the Jönköping Uni-versity’s Library, but also by the use of databases such as JULIA and JSTORE. Also some online libraries were used, one of them was ebary. As a good way of extending the list of ar-ticles and books we looked into suggested reading- and references lists from relevant work-ing papers, articles and books.

With the approach of using the suggested reading- and references lists it was easier to ac-cess good and reliable sources once we found trustworthy articles and books. However, to find the initial and new sources some key words where used regularly, either as standalone or combined with each other. Examples of key words: business- firm- company- corporate

valua-tion, Discounted Cash Flow Model, intellectual capital, human capital, five forces, multiples, knowledge based, risk rating and value drivers.

During the work of setting up the Frame of References we faced a problem that within some areas there where absorbed amount of sources and in other areas the information could only be found in just a few articles and/or books. Due to this it took a lot of time sorting among the information to find the most relevant for our study.

2.4 Interviews

When it comes to collecting primary data there are a wide range of different ways of doing it. The ways of collecting information can firstly be divided into two groups; oral- and writ-ten methods. Among the oral methods there are individual interviews, telephone interview and group interviews. For the written methods there are different types of surveys; for ex-ample individually, in group or by mail/e-mail, and there is also an essay type of survey (Andersson, 1985). We have decided to do an oral interview, more specifically a telephone interview. By choosing an oral method instead of a written is often that you want to create a connection with the interviewed. Another reason could be that you wishes to customize the next question depending on the answers given before and have the ability to explain or redesign the question to clarify the meaning (Eriksson & Wiedersheim-Paul, 2006). By us-ing a method like telephone interview there are both advantages and disadvantage. The dis-advantages are that you might lose some of the personal contact and that the questions cannot be too complicated (Andersson, 1985). On the advantage side it is a cheap and quick method to do many interviews and it has high response ration on this type of inter-views (Andersen, 1998).

2.4.1 Interview Guide and Interview Questions

In the same way as a study can be qualitative or quantitative, an interview can also be done in these two ways. When it comes to a quantitative interview it is more about using the data in statistic, mathematic and formulas in a way to explain a phenomenon. A typical example of a quantitative interview is to ask 200 students, with a simple survey, about how much

8 beer and wine they are drinking in a week (Andersen, 1998). A qualitative interview will on the other hand have easy and straightforward questions, but, the answers to those will be complex and comprehensive. After successful interviews one can have rich and hopefully good material, which by hard work and a bit of luck turn into a great conclusion. You might even come up with something no one else has done before (Trost, 2005).

The key to do a first-class interview is to formulizing the questions in a way that the pur-pose and desirable result are well defined. It is also a must to describe who is behind the re-search and how the material collected will be used. The people being interviewed surely have questions why he or she has been elected for this study and it can therefore be good to explain the selection process (Andersson, 1985). Another crucial moment in an interview process is to select the appropriate interview type, it should be the most suitable for the specific interview situation (Trost, 2005).

Interviews are usually having one of the three characteristics or a combination of them; open-end, multiple chose or ranking questions. The characteristic of question you should use is once again a matter of the specific interview situation and the purpose of the re-search. By using open-end it allows the interviewee full scope and they may open the door to a great report. If you as an interviewer are looking for open answers, open-end questions should be used. Even if you are interested in a specific area, the questions should be spe-cific but open-ended to get the most out of the interview (Benjamin, 1981).

2.4.2 Our Interview

The main goal with this research was to get a deeper understanding about how people in the valuation industry are valuing private limited knowledge based companies, in order to investigate the need for new tools concerning the problem of estimating intellectual capital. Therefore we chose an approach that will get us in contact with actual valuators within this specific business field, since we believed that they will have the knowledge and experience to help us fulfil our purpose. According to Andersen (1998) an interview method with open-end questions is most appropriate for a qualitative interview method. We decided that this was the best approach for our study, and chose telephone interviews as our method of collecting information, due to the fact that most of the people we wanted to interview are working in Stockholm and are very busy. We chose this method firstly to have a higher re-sponse rate and secondly due to the low cost and time spent on each interview.

Before actually interviewing, it is important that the research purpose and the frame of ref-erence are actually represented in the interview guide (Andersen, 1998). Therefore a lot of effort and time were put into the interview guide, to ensure that our purpose and theories was related to the questions in order to get as valid answers from our interviews. Since in-terviewing is very time consuming for both parties it is very important to get all the rele-vant information needed at interview and not have to contact the interviewees an addi-tional time for extra questions. Still we asked all our interviewees if they agree to being

con-9 tacted again for complementing questions or if something needed to be clarified, which they agreed to in order to ensure that we could answer our purpose.

To make sure that our interviews had a better flow and a higher validity we e-mailed our in-terview guide and an explanation of the purpose of our thesis to all our inin-terviewees before the actual interview. It was done in order to assure the respondents that we were asking the questions for a study not at we were journalists seeking information. This also provides the interviewee the opportunity to be better prepared and also get an understanding of our re-search problem and the direction of the thesis. This we believed would help us retrieve more information from the interviews. However that also led to that we got two of our terviews in email format, even though it was stated that we were looking for telephone in-terview. They did not have the time for an interview but we still think their answers are valid since they were part of our sample of potential interview candidates.

During the interviews only one of the authors was participating since it was a telephone terview it would get very messy with too many participants and we believed that more in-formation would be lost instead of the opposite. Since most people in this business field are very busy we thought it would be more suitable with one contact partner in order to es-tablish a better relationship with the interviews. All the interviews were conducted in Swed-ish, which was natural since it is the mother tongue for both the interviewees and inter-viewer. Except for the interview with DnB NOR which was a mix of Norwegian and Swedish. The information received from the interviews as well as the interview guide was translated into English due to the format of writing. The disadvantage with this is of course the translation and the risk that some information will be wrong due to languages difficul-ties but we believed this risk to be very small. We also thought the ability for the inter-viewee to speak in their native tongue will provide greater benefits than the potential loss of the translation.

For the thesis to get a higher validity all the interviewees were asked to read through their answers before publishing. This reduces the risk for any misunderstanding that could have accrued during the interviews, since it gave the interviewees the possibility to verify that they have been correctly interpreted.

2.5 Interview Selection Process

The main objective with our interviews was to collect information from people within the valuation industry, we believed that these people working with mergers and acquisitions could posses the most knowledge and expertise within this field and therefore they were the main target group. People working with valuation can mostly be found within the cor-porate finance department of banks or audit firm but also in private equity firms. Therefore we conducted a list of potential interview candidates for our thesis.

10 We had to conduct an extensive screening process in order to find our respondents. We contacted five auditing firms, five commercial banks, eight larger private equity firms, ten smaller private equity firms and three government agencies. Due to either; lack of time, no personal resource or other difficulties such as strict company policies or the lack of knowl-edge not all organisations could or wanted to participate. The sample for our research pa-per turned out to be eight companies in varies business fields, one thing that all respon-dents had in common was that they are working at a corporate finance department. The corporate finance department core function is advice services that are provided to various corporate bodies about the financial aspect of their operations for example; allocate money to run the business and make it grow, make acquisitions and plan for its financial future (PriceWaterhouseCoopers, 2009b).

The companies we chose to contact are all on daily base working with valuation within the corporate finance department providing qualified services such as firm valuation and pro-curement of capital. They are involved through the entire process of the transaction chain from the analysis, valuation, due diligence and further development towards counselling and problem solutions in relation to business transfers, re-structuring, and financing. Our respondents have a lot of experience and knowledge of providing such services for a long time and these companies also possess a lot of skills and hence are able to offer corporate finance solutions and that is why they were contacted.

These companies provide advisory services in the domain of corporate finance in the fol-lowing fields:

 Solutions related to Problems of Business Operations  Mergers and Acquisitions

 Planning of Business Services  Generating Funds

2.6 Validity and Reliability

When doing a research it is up to the researchers to convince the readers that the study is reliable and valid (Ghauri & Grønhaug, 2005).

Validity is referring to the instrument or question that should be measured is the inten-tional ones. For example if I am interested in knowing how many days in a week people are reading the newspaper, the expected answers should be in days not very often or rarely. Simply, is the study correctly reflecting the specific concepts the authors’ are attempting to measure (Trost, 2005). There are some problems with validity, since no experiment can be perfectly controlled and no measuring instruments can be perfectly standardized (Kirk & Miller, 1986). Issues affecting the validity in a study in a negative way can be for example

11 stress or misinterpretations; different people interpreting information differently (Yanow & Schwartz-Shea, 2005). An issue for our thesis could be that we misunderstood our respon-dents, it is easily done for a telephone- than a face-to-face interview. We addressed this concern by sending the empirical findings to our respondents before publishing, in order for them to agree with the information presented.

When talking about the steadiness of the measures it is referred as the reliability of the study. In other words, despite the consequences of who is conducting the studies, the re-sult should be the same as long as the same method is used (Ghauri & Grønhaug, 2005). A problem with reliability is that the statistical relationship is a most. The reality looks differ-ent, meaning that the results will be different at different times and it is expected. Reliability is built up on a quantitative study and that all variables are a fixed unit. This means that it is more or less meaningless to measure the reliability for qualitative studies or interviews (Trost, 2005). Due to the limitation of our sample of only eight respondents our findings could differ, if other people in the industry would be contacted. However we believe that that the findings are relevant since the respondents are representing some of the biggest ac-tors in the market form different types of businesses. Due to the consensus of our respon-dents’ answers we believe that a larger sample would not differ significantly.

Reliability and validity are by no means symmetric, it is relatively easy to obtain perfect reli-ability with no validity. However, perfect validity would guarantee perfect relireli-ability, for every observation would yield the complete and exact truth (Kirk & Miller, 1986).

One of the biggest problems with doing a qualitative study or interview is the trustworthi-ness. As a researcher you have to convince the readers through the data collection and analysis that the study is trustworthy. This means that you have to show that the data is col-lected in a trustworthy way and especially that it is relevant to the purpose. A good way of increasing the trustworthiness in a study is to describe how and what questions have been used. By showing openness about the way of collecting information will give better re-sponses then keeping it a secret (Trost, 2005).

2.7 Criticism of Method

Even though secondary data usually can generate higher validity, in the way it can be easily verified by others unlike the data one collect them self. We concluded that, the way our purpose was constructed, the collection of primary data was most suitable and correct for this study, since we wanted to investigate the valuation process of knowledge based com-panies and its transient intellectual capital. Most secondary data concerning this topic is mostly about business valuation in a broad perspective and aimed more towards manufac-turing industries. We determined that the cost of obtaining primary data was much lower compared to a biased result caused by secondary data. The choice of using a qualitative method can generate that the analysis will be biased on the writer’s own knowledge, experi-ence and emotions due to the fact that the information gathered is not quantified (Holme

12 & Solvang, 1997). This issue is evident for every researcher conducting a qualitative analysis and we have tried to be as objective as possible in order to produce a non-biased result and analysis.

The method of selecting our sample of respondents can be critiqued since we did not go through any database to find our respondents. Since the specific business field of valuation is limited and that many of the companies that provide these services are well known for most people with an interest within finance we argued for this to be an adequate founda-tion for our sampling. By this assumpfounda-tion we concluded that our sample would still be rep-resentative and be able to fulfil our purpose. When conducting a study about what valua-tion methods most appropriate for a specific service firm it is important to get in contact with the valid expertise and experience.

The disadvantages of using an interview technique as telephone interviewing are that you lose some of the personal contact and do not have the ability to study affect like body lan-guage of the respondents (Andersson, 1985). A telephone interview is one of the most ef-fective ways of conducting an interview and due to the stressfulness of the business the is-sue of time was a big concern. We determined that this approach was most suitable since we wanted to get in contact with as many different candidates as possible. Also many of the respondents firms are located in Stockholm making it almost impossible to conduct this paper within the time restriction. Another disadvantage with telephone interviews is that the questions cannot be too complicated. This was never considered an issue since we contacted our candidates because of their expertise and experience within the field.

Another potential disadvantage of our interview approach might be, sending the interview guide with our questions to the interviewees in advance. There then exists a risk that the answers can be manipulated (Saunders et al. 2003). We believed this risk to be very small since the information shared from the respondents is not of sensitive nature. Also it is be-lieved that the extra information can be received due to this since the interviewees get the chance to read through and think about the answer in advance with the purpose of the study in mind and we believed that this would generate more value for our thesis.

Every method chosen would have its limitations since there exist no single prefect ap-proach, we believed that the different choices made within the research approach best re-flected our problem statement and guided us in order to fulfil our purpose.

13

3

Frame of References

This chapter will begin with a description of why a business valuation is needed and what due diligence is. It will be followed by a deeper understanding of the financial- and non-financial analysis. A discussion about the tax considerations and relevant theory for the analysis before the chapter is ending with a summary of the theories used.

3.1 Motives for Valuation

Within today’s business world with a more global environment and mergers, acquisitions, Initial Public Offering (IPO) and raise of new capital are daily challenges of managers, a business valuation is more important than ever (PriceWaterHouseCoopers, 2005). Whether you are a prospective investor, a member of the board or the manager, knowing and under-standing the value of the company and the process of valuation is always beneficial and in some situations crucial. As mentioned earlier, valuations are carried out for many different situations by different parties, for different reasons (Frykman & Tolleryd, 2003). The pur-pose of a valuation is determining the direction and range of the executing work. For ex-ample, if the purpose of the valuation is for an IPO it will be more extended than if it is for the board to just have knowledge about the value. The purpose is also important to know since it is defining what values to put specific weight on and use as benchmark for the valuation (PriceWaterHouseCoopers, 2005).

3.2 Due Diligence

According to Nationalencyklopedin (2009b) due diligence is an in-depth company investi-gation of the firm’s legal, financial and markets oriented aspects before, for example, a merger or acquisition. A due diligence analyze is usually done to give the new potential owner their own picture of the company, but also as a tool to control to that the informa-tion given by the owner is agreeable with the reality.

A due diligence analysis is almost never the same for two companies, one of the reasons is due to what the seller is prepared to show in this phase of the selling process (PriceWater-HouseCoopers, 2005). In the beginning of a due diligence analysis an overview of six dif-ferent areas are analysed. A commercial analysis is conducted to give the buyer a broader un-derstanding of the environment the company is active in. During the transaction process it is also necessary to get the basic knowledge of the market dynamic and the commercial risks that are affecting the business (Deloitte, 2009a). The financial analysis is normally an accurate review of the company’s financial numbers, such as revenues and cash flows and so on. Other analysis that is conducted is operational analysis which is concentrated to the daily functions in the company. Environmental- and legal questions are also areas where the potential buyer is looking at (Lawrence, 1994).

14 A due diligence analysis is not done by every potential buyer, it is only at a specific point in the transition process the analysis is interesting. At this point the potential buyer has given a cause of the acquisition and an indicative offer. The result of the due diligence gives the buyer decision-making basic data about the objective and a foundation when the price is negotiated (PriceWaterHouseCoopers, 2005).

In the case of mergers and acquisitions it is very common that the buyers are conducting a due diligence. However, more and more sellers are doing the same, a so-called sell side due diligence. Due to the fact that they what to be prepared and increase their knowledge about their own company. This can be valuable knowledge when starting a price negotiation (Lawrence, 1994).

3.3 Financial Analysis

Analysts are using a wide range of models when doing the financial valuation of a com-pany. It is everything from simple models to extremely complex ones, the models often make very different assumptions but they do share some common characteristics. In gen-eral, there are three main valuation approaches. The first, discounted cash flow model is used to see the value of an asset by using the present value of future cash flows. The sec-ond, relative valuation is looking at comparable variables such as earnings, book value, sales and so on. The final, contingent claim valuation is using option pricing models to measure the value (Damodaran, 2002). The last model will not be used in this paper due to the fo-cus is on private limited companies and thus firms do not have public traded shares and options making it really difficult to value. The input for the value of the underlying asset cannot be found in the financial market and therefore assumption has to be made increas-ing the errors.

When analysing a company’s business and their environment the quality of the valuation is crucial for the result. To conduct a good analysis you need to master the Discount Cash Flow (DCF) calculations, however, when that is done the focus should shift to the value creation process within the firm (Frykman & Tolleryd, 2003).

3.3.1 Discounted Cash Flow Model

Discounted cash flow valuation (DCF) relates to the value of an asset to the present value (PV) of expected future cash flows on that asset and is the foundation on which all other valuation approaches are built. This approach has its foundation in the present value rule, where the value of any asset is the present value of expected future cash flows (Damoda-ran, 2002). The DCF model looks like this:

15 𝑉𝑎𝑙𝑢𝑒 = 𝐶𝐹𝑡

(1 + 𝑟)𝑡 𝑡=𝑛

𝑡=1 Where n = Life of the asset

CFt = Cash flow in period t

r = Discount rate reflecting the riskiness of the estimated cash flows

This model is providing a reliable and detailed insight into the value of the company (Cope-land et al, 1990) and it is the most trusted and utilized valuation method (Weston & Weaver 2004). This method calculates the present value of all the future free cash flows (FCF) generated by the company know as the discounted cash flow (DCF). By calculating FCF it is assured that the CF generated is available to the providers of capital both equity and capital (Copeland et al, 1990). The value of the firm’s equity is equal to the present value of the net cash flows generated by the firm's assets, including the present value of in-vestments made in the future. The free cash flow approach estimates the value of the firm as a whole and derives the equity value by subtracting the market value of non-equity li-abilities (Damodaran, 2002).

There exist differences depending on the purpose of the valuation; one can either value the whole firm or just the equity. When evaluating the equity one start from the net income compared to when evaluating the whole firm then one start with the cash flow from EBIT, also called free cash flow to firm (FCFF). The second step is to calculate how much the firm has invested in order to create predictions about future growth and lastly the cost of equity or cost of capital has to be estimate determining the discount rate (Damodaran, 2002).

The FCFF is calculated from the income statement and can be a bit different depending on the purpose of the valuation and if the firm is levered or unlevered. It can look like this:

Revenues

- Operating Expenses = EBITAD

- Depreciation and Amortization = EBIT

- Taxes = Net Income

+ Depreciation and Amortization = Cash Flows from Operation - Capital Expenditures +/- Working Capital Change = FCFF

16 The difference for a levered firm is that principal repayments get deducted and proceeds from new debt issued get added after working capital changes (Damodaran, 2002).

Cost of Equity is somewhat difficult to determine with accuracy since it is impossible to know what every investor require in terms of return on their investment. The cost of equity is built up by a risk free rate, the market risk premium and an equity beta and is estimated using the dividend growth model or the Security Market Line (SML) approach (Damoda-ran, 2002).

The most commonly used approach to estimate the risk free rate is to use the US Treasury Bonds as a benchmark. There should not exist any default risk or reinvestment risk. Market risk premium is the estimated excess return in the market portfolio compared to the risk free rate and is a premium for average risk investment. The premium consists of the base equity premium and the country risk premium (Damodaran, 2002).

The equity beta is the systematic risk of a risky asset compared to the relative market risk and can be seen as the assets tendency to swing with the market. Beta is calculated as a re-gression analysis between the market and the chosen asset. A beta of 1 indicates that the asset has the same volatility as the market, while a beta higher than 1 indicates a higher volatility than the market and vice versa (Damodaran, 2002).

The WACC Formula is used in order to weight the market value proportions of the dif-ferent components of financing used by the firm. The relative weight of cost of equity and debt adjusted for the tax effect will be the weighted average cost of capital (WACC). It is the return that a company has to earn on its assets to maintain the stock value. When valu-ating using the discounted cash flow model, the discount rate will be the WACC since it is the required rate of return on an investment made by the firm with the same risk as the ex-isting operations (Damodaran, 2002). The WACC formula looks like this:

𝑊𝐴𝐶𝐶 =𝐸

𝑉∗ 𝑟𝐸 + 𝐷

𝑉∗ 𝑟𝐷∗ (1 − 𝑇𝐶) Where:

V = Combined market value of debt and equity (E+D) E = Market value of equity

D = Market value of debt RE = Cost of equity RD = Cost of debt TC = Tax rate

17 3.3.2 Profit Margin

It is of most importance for firms to keep their margins as high as possible since costs are continuously rising and the growing competition on the market forces companies to be-come more competitive advantage in their services or products (Doyle & Corstjens, 1983). Margins are good estimate for service firms since many of their products/services do not have large costs. For production firms cost reduction is a very powerful competitive weapon, since there exists many different ways to make the production process more effec-tive and efficient and thereby lowering cost and increase margins. For many service com-panies the biggest cost is their employees and that is also their most important asset (Ben-nett, 1966).

Profit margin is a common key ratio in order to determine the profitability of a firm. It il-lustrates the firms profit in relation to the turnover, other relevant margins is gross margin. The prices of the services the firm offer its end customer have to be able to cover not only the cost associated with the development and value chain but also include a profit margin (Fairley, 1979).

3.3.3 Relative Valuation Approach and Multiples

The objective of relative valuation is to value assets based on how similar assets are cur-rently priced in the market and it consists of two components (Damodaran, 2002). The first is to value assets on a relative basis making them standardized by converting prices into multiples of earnings, book value or revenues. The second part is to find similar firms, but even firms within the same industry often have different risk, growth potential and cash flow. The main task when using relative valuation is to handle these differences cor-rectly when comparing multiples across firms (Damodaran, 2002).

An isolated number do not have any significance, it is not until it is compared against a standard value one can determine if it is satisfying or not. The relative valuation approach relies on that the market sets on average correct prices and that the errors will be corrected over time. This approach is widely used due its simplicity and quickness, it needs fewer as-sumptions and is easy to present and understand and also reflects the current state of the market. The approach can either use fundamentals, similar to the discounted cash flow model, or use comparables. The advantage of using fundamentals is that it shows the rela-tionship between multiples and company characteristics, but the most commonly used is comparables which compare multiples to see how the company is valued. The comparison is usually done by comparing multiples against other similar firms within the same industry but one can also compare multiples over time (Damodaran, 2002).

The strengths of relative valuations is also its weakness, the ease with putting together a multiple and a group of comparable firms, can result in inconsistent estimates, where key variables like risk, growth or potential cash flow are ignored. The fact that relative valuation

18 reflects the mood of the market can lead to overvaluing and undervaluing. The biggest flaw with this theory is that it is particularly vulnerable to manipulation, due to the lack of trans-parency regarding the underlying assumptions. The most common multiples to analysis is earning, book value and revenue multiples (Damodaran, 2002).

Earnings Multiples: The price-earnings ratio is the ratio of the market price per share to the earnings per share. It reports how much the purchasers of stocks must pay per dollar of earnings that the firm generates and can vary a lot across different firms. A high P/E ra-tio usually indicates that the firm has potential to grow. P/E is calculated by the formula (Damodaran, 2002); 𝑃𝐸 = 𝑃0 𝐸𝑃𝑆₀ = 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 1 + 𝑔𝑛 𝑘_𝑒 − 𝑔_𝑛 Where;

P0 = Value of the stock today EPS0 = Earnings per share in year 0 g_n = Growth rate after n years ke = Cost of equity

A multiple that can be used on more firms is the EV/EBITDA since fewer firms have a negative EBITDA than the number of firms that have negative earnings per share. There-fore in depreciation methods do not affect EBITDA, but it affects operating income and net income. The multiple is also more useful when comparing firms with different financial leverage. Value to EBITDA is calculated by the formula (Damodaran, 2002);

𝐸𝑉 𝐸𝐵𝐼𝑇𝐷𝐴= 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑑𝑡 − 𝐶𝑎𝑠𝑕 𝐸𝐵𝐼𝑇𝐷𝐴 Where; EV = Enterprise value

EBITDA = Earnings before interest, taxes, depreciation, and amortization

Book Value Multiples: The estimates of the value of a business often differ a lot. The book value of assets is heavily influenced by the original price paid and accounting adjust-ments, such as deprecation. In order to see if a stock is over- or undervalued one usually look at the relationship between the price paid for the stock and the book value of equity. The Price to Book Value (PBV) can differ a lot between industries since it is depending on the potential growth and is also heavily influenced by the return on equity (ROE). When valuing an entire business the book value of all assets is used rather than just the equity. The PBV for a stable-growth firm is calculated by the formula (Damodaran, 2002);

19 𝑃₀ 𝐵𝑉0 = 𝑅𝑂𝐶 ∗ 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 𝑘𝑒 − 𝑔𝑛 Where;

ROE = Return on Equity g_n = Expected growth ke = Cost of equity

Revenue Multiples: For young firms that have negative earnings, multiples of revenues are more accurate than a multiple of earnings. A revenue multiple such as, value to sales (V/S) can measure the value to equity or the business relative to the revenues that it gener-ates. When using revenue multiples it is much easier to compare firms in different markets compared to the use of earnings or book value multiples (Damodaran, 2002). V/S is calcu-lated by the formula;

𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒0

𝑆𝑎𝑙𝑒𝑠 =

After tax operating margin ∗ (1 − 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒) 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑔_𝑛

Where;

EBIT = Earnings before interest and taxes gn = Expected growth

Multiples Related to Employees: It is important to know that the number of employees is one of the most common measure concerning the company’s size and growth. These measures can be divided into different key figures; turnover per employee, value added per employee, employees in different categories etc. This measure is suitable when one follows up the company over time and the ratio can be used to compare the company with other companies within the same industry. For personnel intensive companies the measure, growth in relation to employees, can be an important measure since these companies’ re-sults are highly dependent upon the employees.

3.4 Non-Financial Analysis

When doing a non-financial analysis all information and variables affecting the firm’s value should be considered, which will be a great number of variables and will make the valuation very difficult to work through and use. In order to make the underlying analysis easier to implement the analysis is usually focusing on so-called value drivers (Hitt at al, 2002).

20 3.4.1 Value Driver

When doing the valuation it is necessary to understand where the company is creating their value, which means identifying the value drivers for the business. Having an understanding about the value drivers and their effect on the company’s future cash flow will be a great help when estimating the input variables in the DCF model (Coperland, Koller & Murin, 1994). Within today’s businesses there are hundreds of value drivers adding up to the whole firm’s value. Value drivers exist on all levels in an organization, but they are catego-rized into two groups, financial value drivers which are more often at top management lev-els where the value driver usually reflect the overall performance of the company, measur-ing the past period. Examples of financial value drivers are; Return on Invested Capital, Re-turn on Equity, Revenue Growth and so on (Frykman & Tolleryd, 2003). The other group is operating value drivers, being used as early indicators of the company’s future perform-ance and cash flow. Examples are Customer Brand Loyalty Index, Investment in Brands, Motivation Index, Corporate Quality Performance and so on (Coperland, Koller & Murin, 1994).

When executing a valuation, understanding and determining all value drivers is not neces-sary, nor is it recommended (Frykman & Tolleryd, 2003). You should instead focus on the a few variables generating the greatest overall value, these variables are distinguished as “key value drivers”. Whish value drivers that are the most important differ from company to company and industry to industry (Coperland, Koller & Murin, 1994).

To identify the key value drivers within a company is not easy, since it requires understand-ing of the firm’s whole value creation process. Just because one found the key value driver once does not mean that it never has to done again, they can change over time. It is rec-ommended to look at the effect of changes in the key value drivers and also to understand how the different value drivers are related to each other (Frykman & Tolleryd, 2003). Understanding the key value drivers is one of management’s most important tasks since it is clearly difficult to maximize value without knowing where it is created (Coperland, Koller & Murin, 1994).

3.4.2 The Structure of the Underlying Analysis

The underlying analysis is divided into three parts; an external part consisting of macroeco-nomic analysis of the overall economy focusing on factor affecting the company and an in-dustry analysis of the industrial structure in which the company operates. The focus in this part is on the industrial analysis instead of the macro-factors since those factors are also af-fecting the industry. The second part is the internal resources also called, intellectual capital. In this part the company’s intangible resources are analyzed, for example employees’ knowledge, intellectual property and processed documents. The last part is the corporate

strategy, being the link between the two other parts. This part is also about how the

21

Now the basic structure of the underlying analysis is presented briefly, below the ability of a deeper under-standing in the industry structure and the intellectual capital is given based on well-known models. After that a presentation of the most common non-financial value drivers are presented in more detail and a framework for the underlying analysis is presented.

3.4.2.1 Industry Structure

The first step towards formulating a competitive strategy is to define the industry structure within which it is operating and an analysis of that industry is always necessary for a valua-tion in order to make as correct assumpvalua-tions as possible (Porter, 1980).

When analyzing the industry structure the famous Harvard professor Michael Porter’s “five forces” model will be used, see figure 3-1. Porter’s “five forces” combined power is decid-ing the potential profit in the industry. The “five forces” are Rivalry, Barriers to Enter and to

Exit, Substitute Products, Suppliers Bargaining Power and Customer Bargaining Power, each “force”

will be described additionally below.

Figure 3-1 Porter’s Five Forces

Barriers of Entry and to Exit is a normally the way of referring to factors that make it more difficult and/or expensive to establish a presence in a market or exiting the market. There is a difference between natural barriers to enter such as economic of scale, strong brands, partners or capital needed. Then there are the unnatural barriers such as regula-tions, tariffs and monopolies in the market. The best scenario for a firm that already is in the market would be costly/high barriers to enter but almost no extra cost/low barriers to exit. This situation sets a profitable environment where the risk of price competition is low.

22 The worst case scenario would be the opposite resulting in that many firms are entering the industry in good times and nobody leaves during bad times (Frykman & Tolleryd, 2003). A Substitute Product is a product/service that is fulfilling the same needs or functions as yours but it is product or delivered by another firm, a competitor. If there is a substitute product on the market it will limiting the profitability in that industry and also set an upper limit to the price of the product (Porter, 1980).

The relative bargaining power of Customers (buyers) and suppliers reflect the well known supply-demand axis in any famous strategic models. Buyers influence determines the prof-its that can be gained from a product will you meet the price and quality demand (Porter, 1980). Customer can influence the profitability of the industry by demanding lower prices, better service or better performance. Factor that can raise negotiating power could be that customer are more concentrated than the sellers and buy in large quantity or customers have very low cost of changing supplier (Frykman & Tolleryd, 2003).

Suppliers (seller) can influence the profitability of an entire industry, almost in the same way as customers, if they have a strong position. For example, they can rise prices, decrease the service level or take a number of other actions affecting the structure of the industry (Frykman & Tolleryd, 2003). Porter (1980) also saw the workforce of an industry as a sup-plier influencing the cost of production. Situations where the negotiating power is high for the suppliers are when the supplier industry is dominated by fewer companies and more concentrated to the industry they provide. Another example is when the industry in ques-tion is not an important customer for the supplier. When the competitive balance and natu-ral profitability in the industry is set a structunatu-ral analysis would be the next step in strategic planning (Porter, 1980).

Rivalry is that companies in the same industry are mutually dependent on each other, meaning that if one firm does a competitive move it will have an effect that others in the industry provoke a countermove (Porter, 1980). Of course, rivalry works differently in dif-ferent industries and is also affected by many difdif-ferent factors. In generally, an industry with high rivalry is often an industry where the profit is lower (Frykman & Tolleryd, 2003). The best scenario for a single company, but probably not the best for its customers, would be that rivalry is low for example due to high growth in the industry, few players on the market with very different products and/or no barriers to exit (Porter, 1980).

By analyzing the “five forces” you will have a better understanding about the industry your company is active in. Does this industry have high profit potentials? Is the profit going to remain the same? This means that the “five forces” is an excellent tool to analyzing the cur-rent and future situation for the industry. Porter (1985) also pointed out that, the strategy is about making choices to pursue things a firm wants and overlook things it does not want, no firms can be able to do everything for all people. By this, he means that firms have to set limits on what they are trying to accomplish to become unique which sometimes re-quires trade-offs between interconnected options to achieve fit.

23

3.4.2.2 Intellectual Capital

When talking about intellectual capital there are people arguing that it is easy to set a value and define it. It is just the difference between the market value and the net asset value of the company. There are also other people considering that to be wrong, arguing that intel-lectual capital is much harder to define and especially to set a value on (Roos, Fernström & Pike, 2006). When it comes to high-growth- and knowledge based firms it is even harder. These people mean that the net asset value have very little to do with the market value and it is not possible to explain the different between them using intellectual capital alone (Frykman & Tolleryd, 2003). There are much more that affects the market value, such as macro economical variables, the company’s industry structure, business strategy and many more. A more correct definition would be: all non-financial assets of a company that are not reflected in the balance sheet. By other words, it is extremely hard to put a value on (Stewart, 1998).

Today there is no good model of calculating the intellectual capital within a company, this is also the case for the industry structure framework presented in section 3.4.2.1. The in-dustry structure has proven to be an important part in a company valuation (Hansson & Anderson 1999). There is one framework that has been used when valuing intellectual capi-tal, that is Edvinsson’s (1997) Intellectual Capital Tree presented in figure 3-2.

Figure 3-2 The Intellectual Capital Value Tree

According to Edvinsson (1997) intellectual capital is divided into two categories and differ-ent sub-groups.

24

Capital Group Definition

Structural Capital divided into Customer Capital and Organizational Capital. Human Capital the intellectual recourses possessed by the individuals in the

company and that leaves the company every evening when the employees leave the office.

Customer Capital the value of all the relationships the company has with their cus-tomers.

Organizational Capital divided into Innovation Capital and Process Capital. Innovation Capital consists mainly of brands, patents and documented ideas. Process Capital is all support systems, process documentation, manuals, IT

sys-tems and the like.

(Edvinsson, 1997)

The terminology Human Capital includes more than all the individual capacity, knowl-edge, competence and experience among the firm’s employees and management. It also has to capture the dynamic and flow of knowledge in an intellectual organization that operates in constantly changeling and competitive environment. In order for the human capital to grow within a company the employees and senior management have to develop and im-prove their existing as well as new abilities. The company also has to realize the need for this abilities and competence and incorporate them in the organisation’s operation (Edvins-son, 1997).

According to Roberts (1997) the efficacy and skill with which a company is able to increase its human capital is the real yardstick of its efficiency in the age of knowledge. One ap-proach of create a value for human capital is to divide the employees into categories, ac-cording to their replace ability and the high or low added value they provide. The problem with this is the critical segment where the categorization to determine who is replaceable and who provide high added value; those whose expertise and talent create the products or services, who link the customer to the company.

According to Edvinsson (1997) the Structural Capital is properly described as the incar-nation, enabling and the supportive infrastructure of the human capital, in other words the organisation’s ability transfer and store the intellectual capital within the organisation. It can include IT-systems quality and effectiveness, corporate image, internal databases, organisa-tional concepts and documentation. As can be seen in figure 3-2 the structural capital can be divided into three part; organisational capital, innovation capital and process capital. Ideas are usually floating free and it is the company’s responsibility to manage these ideas and transform that know-how into the organisation’s property. Since the goal for a firm is